"It's easy for a central banker to be popular during euphoric financial times. But the political perils are severe when tough measures are needed - measures that extract a high short-term toll in the interest of longer-term economic health - as they were in the late 1970s."
--Economist Henry Kaufman

As we pick up our story of former Federal Reserve Chairman Paul Volcker, it's the fall of 1979 and Volcker has recently been named chairman, putting his mark on Fed policy by raising the discount rate a full percentage point while emphasizing that killing inflation was his number one priority. Volcker realized he risked putting the economy into recession.

Interest rates soared. While the 3-month Treasury Bill was climbing from 8% in September of '79 to 12.5% by year end, the Fed wasn't counting on long-term rates rising as well, from the 9.2% level in September to 10.1% by December 31st. [In most normal environments, as the Fed is increasing short interest rates (the only thing they can influence directly), the longer end of the yield curve responds positively. Since the longer end represents "inflation expectations," by raising short rates you would expect
to eventually slow the economy and dampen inflation fears. Thus, the premium that investors demand for buying longer-term instruments should narrow, not widen.]

Into early 1980 interest rates across the board continued to rise and the economy tipped into recession (a mild one but an important one as far as the presidential election of 1980 was concerned). By the end of the first quarter, the long bond was yielding 12.3%. Treasury Bills were to peak that year in the second quarter, 15.6%. The inflation rate for the first quarter of 1980, as measured by the CPI was 14.6%.

Awful news. But what we didn't know at the time, as is often the case during events such as these, was that the back of inflation had been broken. By the middle of 1981, it was running at a 9.7% clip and for the year it was below 9%. Volcker was winning.

But the times were tough on the chairman. Henry Kaufman went to visit him in 1980 and he observed that construction bricks were filling an outer office, yet no renovation appeared to be taking place. It turns out that the Brick Layers Union had sent them over, along with a note saying that they were no longer needed. A rather vicious reminder of the troubled economic environment.

1980 was a miserable year for President Carter as well. Inflation, unbelievably high interest rates, a desultory stock market, and the Iranian hostage crisis. Carter went against the policy of the Fed and instituted his own policy of "special credit controls" whereby special requirements were placed on the reserves of banks and credit card companies. Volcker sat by, not wanting to be seen playing politics. Like the price controls of President Nixon, the credit controls worked for a spell and rates declined, only to soar anew.

Reagan won the election that November and, as soon as the votes were tabulated, Volcker began to tighten interest rates more. The federal funds rate, which had averaged 11.2% in 1979, peaked at 20% in June 1981. The prime rate rose to 21.5% in '81 as well.
Treasury Bills hit 17.3% and the long-term bond was on its way to 15.3%.

Upon taking office, Ronald Reagan said that the country faced the threat of economic calamity. But many would say his preferred policies of tax cuts would encourage spending and investment and thus hamper Volcker's effort to kill inflation, once and for all.

Reagan, though, certainly understood the importance of ending the inflation threat and he was willing to endure a deep recession to accomplish this. Already, early in 1981 there were reports that he would be a one-term president.

But while Reagan would remark at cabinet meetings, "Why do we need the Federal Reserve at all?" he let Volcker operate with little interference.

By July 1981 the nation was in recession, and it would be a long, ugly one. [Economists choose November 1982 as the month the recession ended.] The manufacturing sector was decimated plus the combination of high interest rates and an expensive dollar sharply reduced American exports, particularly hurting farmers. In 1982 the unemployment rate hit 9.7%.

Reagan didn't waver. He insisted that if the nation "stayed the course" it would emerge healthier and more prosperous in the end.

Meanwhile, Paul Volcker stuck to his own guns, convinced that firm control of the money supply was the key to a sound economy. And inflation was heading lower. A CPI that registered 13.3% for 1979 was to plummet to 3.8% for all of 1982.

The stock market, which had reacted positively to Reagan's victory in November 1980 with the Dow Jones closing at 953 on the first trading day after the election, was to become a victim of the deep recession of '81-'82 as well. By the summer of 1982 the Dow would plummet to 776 on August 12. But Volcker was increasingly convinced that the time was near to reverse course.

And another figure who was about to turn positive economist Henry Kaufman of Salomon Brothers.

Kaufman's pronouncements on the financial markets were legendary back in the late '70s - early '80s. When Henry spoke, people listened.

I started my career in the financial services industry working in the same building where Salomon's headquarters were. I used to ride the elevator with Mr. Kaufman as our companies were in the same elevator bank. He always looked so glum and we felt like
saying, "Hey, nice comment Henry!" as the market tanked after a particularly negative missive.

But by the summer of 1982 Kaufman was becoming increasingly convinced that a significant interest rate decline lay ahead. The recession, financial blockages and intense international competition augured for a more favorable environment in bond land, and by inference, the stock market. Kaufman decided to become bullish.

On August 17 Kaufman issued a memo proclaiming the worst was over. The financial markets went ballistic. The Dow Jones rallied 38.81 that day (792 to 831) or 4.9% the largest single- day rise in the markets history. A near record 93 million shares changed hands and there were 10 stocks up for every 1 down. And in the bond pits, short-term rates fell about half a point in one day! The Fed cut the discount rate in August and the great bull market that we are still technically in had commenced.

Ironically, as the Fed relaxed policy, money supply growth soared. The Reagan budget deficits began to soar as well. Interest rates were to take another hit to the gut in 1984 as the yield on the long bond hit 14% but, as the realization was also sinking in that inflation was not going to return to the levels of 1979-81, rates fell and the great bull market in bonds was under way.

Paul Volcker stayed on as Fed Chairman until his retirement in June 1987, to be replaced by current chairman Alan Greenspan. While Volcker has remained active in the financial arena, perhaps his highest profile stance since his Fed days was taken during the Long-Term Capital Management fiasco of 1998. Volcker questioned the "bailout" of LTCM by the consortium of investment banks. "Why should the weight of the federal government be brought to bear to help out a private investor?"

I guess they were just too big to fail, Paul. A nasty precedent.

*The Fed is adamant that they were not involved in the LTCM bailout and that this was not government interference in the free markets.

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